The two-factor model for Security X is 3% + l.5(GDP) - 2(CPI) and for Security Y is 4% + 2(GDP) - .8(CPI). An analyst forecasts GDP at 4% and CPI at 5% with respective variances of 8% and 3%. Covariance (GDP, CPI) is .6. The covariance between Securities X and Y is
A) 25.7.
B) 28.8.
C)g.6.
D) 33.6.

Question

Quizplus · Accepted Answer

The covariance between two securities in a two-factor model is calculated using the formula: Cov(X,Y) = b1x*b1y*Var(GDP) + b2x*b2y*Var(CPI) + (b1x*b2y + b2x*b1y)*Cov(GDP,CPI). Plugging in the values: Cov(X,Y) = 1.5*2*8 + (-2)*(-0.8)*3 + (1.5*(-0.8) + (-2)*2)*0.6 = 24 + 4.8 - 3.1 = 25.7.

The Two-Factor Model for Security X Is 3% + L